Poland - Concluding Statement of the 2011 Article IV Mission
May 12, 2011
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
1. Poland returned to solid growth in 2010, building on timely and forceful countercyclical policy responses to the global crisis. These responses were permitted by limited macroeconomic imbalances prior to the crisis and access to a Flexible Credit Line (FCL) arrangement with the IMF, both of which reflected a track record of strong policies.
2. With the economy gaining momentum, it is time to normalize macroeconomic policies, further strengthen banking system resilience, and deepen structural reforms:
• The current substantial fiscal consolidation is welcome. Additional measures will be needed to put government debt firmly on a downward path over the medium term. With capacity constraints tightening, this additional adjustment should begin sooner rather than later.
• Revisions to balance of payments data may raise the reported current account deficit, which would indicate that net national saving is lower than previously thought and thus strengthen the case for additional fiscal saving.
• Recent increases in the policy interest rate have been appropriate. Further gradual increases will be necessary to bring inflation back to target.
• Indicators of banking system soundness are generally stable, though some challenges remain. Financial sector surveillance policies in Poland have been effective, but efforts to further strengthen financial sector resilience need to continue.
• Further raising labor participation would boost potential growth.
3. Economic growth is expected to remain solid and the current account deficit to widen further. Real GDP is projected to grow by 4.0 percent in 2011 and 3.8 percent in 2012, underpinned by steady growth of private consumption, strong EU-funded public investment, and an upturn in private fixed investment. Employment growth should remain solid, leading to a fall in the unemployment rate by 2012. Tightening capacity constraints and the VAT rate hike are pushing up core CPI inflation, while high global commodity prices are boosting headline CPI inflation. Reflecting strengthening domestic demand and high commodity prices, the current account deficit (based on existing data) is expected to widen to 4.2 percent of GDP in 2012, most of which is expected to be financed by net EU capital transfers and net FDI. Financial inflows are expected to remain strong.
4. Risks to the short-term growth outlook are balanced, with external risks mainly on the downside and domestic risks mainly on the upside. Sovereign financing concerns elsewhere in Europe could spill over to funding pressures in core Europe and in turn increase financing costs for Poland. In addition, Poland is closely integrated into Europe’s banking system, making it potentially vulnerable to contagion from financial strains. Poland’s FCL arrangement provides insurance against these risks. A sustained rise in global oil prices would represent a risk to GDP growth. On the upside, increased investor appetite for Polish assets could lead to a surge in capital flows. Also, given improved corporate profitability and tightening capacity constraints, private fixed investment could recover more rapidly than currently envisaged.
5. Welcome improvements to the balance of payments (BOP) compilation system may lower large errors and omissions (E&O) but increase the reported historical current account deficit. Future BOP data releases are expected to lead to revisions to various current account items (such as used car imports and private transfers) and the nonfinancial private sector’s external assets. A higher current account deficit would indicate that net national saving is lower and that vulnerability to external financing shocks is higher than previously thought, as well as affect our assessment of the exchange rate (which we currently see as broadly in line with fundamentals) and could imply a higher projected path for external debt. Revisions to E&O may change the structure of GDP, but are unlikely to change overall growth.
6. Given the large fiscal deficit in 2010, the current substantial fiscal consolidation is welcome. Under its latest Convergence Plan, the government aims to cut the general government deficit to 5.6 percent of GDP in 2011 and 2.9 percent of GDP in 2012. To achieve these targets, consolidation measures are being implemented, mostly on the spending side: tightened eligibility for early retirement, a ceiling of CPI+1 on the growth of discretionary expenditure (which includes a wage bill freeze), a VAT increase of 1 percentage point, and increases in excise taxes. In addition, some pension contributions are being shifted from the private to the public system and there are plans to further restrain local government deficits. In our view, yields from announced policies and tax buoyancy will lower the fiscal deficit to 5.6 percent of GDP in 2011 and 3.6 percent of GDP in 2012.
7. As it is important to put government debt firmly on a downward path, additional fiscal consolidation will be needed. On our baseline projections, the fiscal deficit would fall over the medium term to 2 percent of GDP and government debt would decline slowly to 53 percent of GDP (ESA95 basis). To reduce debt firmly over time, the fiscal deficit should be cut to no more than 1 percent of GDP over the medium term, which is also Poland’s Medium Term Objective (MTO). This would require additional permanent measures of a little more than 1 percent of GDP. Given the tightening of capacity constraints and increased external vulnerabilities associated with an upward revision to the current account deficit, it would be good for this additional adjustment to begin sooner rather than later. Measures that could be considered include tightening pension indexation, aligning disability benefits with the pension formula, improving the targeting of other benefits, increasing the flexibility of the floor on defense spending, streamlining public administration employment, limiting tax reliefs and exemptions, and enhancing VAT yields.
8. The government’s intention to adopt a permanent fiscal rule, which would set a ceiling on spending growth, is welcome. We recommend that the spending rule be anchored by the medium-term deficit target (such as a “debt brake” that would reduce spending growth if the deficit consistently exceeds the MTO). Such a rule would be effective in restraining debt while allowing for some counter-cyclicality and would be linked to the MTO. The fiscal rule should be complemented by strengthening the implementation of the ongoing multi-year budgeting reforms.
9. The shift of some private pension contributions to the public system will improve government debt dynamics, but should not be allowed to facilitate higher spending or tax reductions that could weaken long-term fiscal sustainability. Given the long-term decline in replacement ratios and the corresponding need to increase national saving, we recommend either strengthening the target for the fiscal balance or increasing contributions to the second pillar, once fiscal space allows. A funded second pillar is potentially beneficial from international risk-diversification and capital-market development perspectives.
Monetary and exchange rate policy
10. We welcome the recent increases in the policy interest rate and support further gradual hikes in the policy rate. The appropriate pace of monetary tightening will depend on the evidence on capacity constraints, as well as developments in inflation expectations, labor markets, the exchange rate, and possible second-round effects from higher fuel prices. On our baseline projections, further gradual hikes in the policy rate by about a cumulative ¾ percentage point over the coming 12 months would bring inflation back to the target over the policy horizon (18–24 months). We welcome the increased discussion of the inflation outlook in the post-MPC meeting communiqué and recommend further elaboration.
11. The recent decision to convert some EU funds on the market needs further clarification. Market conversion implies a slower buildup of foreign exchange reserves by the central bank, which will contain sterilization costs. However, while reserves are more than adequate on most measures, we see scope for some additional reserve accumulation. In addition, we would recommend that the Ministry of Finance be transparent and non-discretionary in its sales of foreign exchange, so as to minimize potential exchange rate volatility.
Financial sector policies
12. Indicators of banking system soundness were generally stable in 2010, but some challenges remain. While the average non-performing loan ratio crept up to 8.8 percent, profitability increased further and the average capital adequacy ratio rose to 13.8 percent at end-2010. Central bank stress-tests show that most banks are resilient to adverse shocks. Corporate credit growth remained low, mainly reflecting weak demand. Mortgage lending grew briskly, with the share of foreign-currency-denominated (FX) lending in new mortgages rising through the year to 23 percent (FX mortgage loans account for over 60 percent of the total stock of mortgage loans).
13. Financial sector surveillance policies in Poland have been effective, but efforts to further strengthen financial sector resilience need to continue. We welcome the introduction of Recommendation T (on household lending) and the recent reinforcement of Recommendation S (on FX mortgage lending). Depending on the impact of KNF recommendations, further steps could be considered. The Financial Stability Committee has become an effective forum for regular discussion of financial stability issues between the financial supervision agency (KNF), the central bank, and the Ministry of Finance. Nonetheless, there are areas where financial supervision could be further improved, including through more frequent on-site inspections. The authorities should consider increasing the independence of the KNF and giving it broader authority to issue binding regulations. Regarding macro-prudential issues, the authorities should consider developing a framework for coordinating policy responses to systemic risks, in line with evolving international thinking. Finally, the bank resolution framework should be strengthened through the adoption of a broader range of tools.
14. We welcome the authorities’ intention to introduce a financial stability contribution in the form of a levy on adjusted bank liabilities, with proceeds earmarked for increasing a bank resolution fund.
Policy options in the event of excessive capital inflows
15. If capital inflows were to increase sharply, monetary policy should be tightened more gradually while fiscal consolidation should be accelerated. As the exchange rate is not presently overvalued, some appreciation would be acceptable. This would dampen inflationary pressures, thus reducing the need for increases in the policy interest rate. If a surge in capital inflows were to put excessive pressure on the exchange rate, then the authorities could consider increasing the pace of reserve accumulation within the prevailing monetary policy guidelines, and accelerate the already-envisaged fiscal adjustment, which would also reduce the need for interest rate increases. In addition, targeted macroprudential measures (such as measures to tighten bank lending standards and increase their capacity to absorb shocks) could complement the macroeconomic policy response.
16. Further raising labor participation would boost potential growth. Poland’s labor participation rate has increased over the past three years, reflecting in part the reform of early retirement privileges, but remains low compared to the EU average. Therefore, we see scope for labor-supply enhancing measures with a complementary long-term fiscal effect, such as raising the retirement age and equalizing it between men and women, and merging special pension schemes within the general system. We also support the extension of the anti-crisis provisions for flexible employment, which are set to expire at end-2011. In addition, Poland has recently made progress toward improving the business environment, including by limiting documentation requirements, broadening the use of information technology in VAT invoicing, and stepping up the pace of privatization.
17. We support the authorities’ strategy of making further progress toward convergence before announcing a target date for euro adoption. In particular, it is important to make the necessary changes to the Constitution and get closer to meeting the entry criteria on a sustainable basis before entering ERM2.